Euro zone carry trade has limited shelf life

The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

The carry trade is alive and well in Spain and Italy. Banks are loading up on sovereign debt, thanks to the wave of liquidity from the European Central Bank’s cheap three-year loans. But local lenders can’t fund Madrid and Rome indefinitely, and with markets still dysfunctional, money could run out sooner than expected.

Spanish and Italian banks borrowed 220 billion and 140 billion euros of new money, respectively, under the ECB’s cheap three-year facilities. So far, they have mainly used the cash to replace privately-held bonds that are falling due, or to buy government debt. Spanish banks have bought 85 billion euros of sovereign paper between December and April, while Italian lenders have propped up the state to the tune of 77 billion euros. That’s allowed the two countries to carry on borrowing when international investors are scarce.

In theory, this could carry on for a while. RBC estimates Spanish banks have 82 billion euros of ECB cash left over – double the 41 billion euros that Madrid still needs to raise this year. As some investors – particularly domestic ones – are likely to swap maturing government bonds for new ones, Spain may only need 20 billion euros of new money. Italian banks, meanwhile, have 53 billion euros of ECB firepower, according to RBC. If domestic investors play ball, the government’s funding gap this year is around 70 billion euros.

Moreover, despite their recent splurge, banks have room to increase their holdings. Sovereign bonds account for just 7 percent of total balance sheet assets in Spain and 7.8 percent in Italy. In 1999, the share in both countries was over 10 percent. In Japan, it’s 23 percent.

However, larger banks like Santander, BBVA and UniCredit are unlikely to increase their sovereign exposure. Smaller banks face less scrutiny from markets, but also have less spare liquidity. Besides, banks have more pressing needs: Spanish lenders must refinance about 65 billion euros of funding this year, and there’s little prospect of them being able to tap wholesale markets.

The carry trade is not sustainable for banks or governments, which are already dangerously entwined. Unless foreign investors make a return, new buyers like the ECB or the euro zone bailout fund may have to step in.